October 12, 2006 4:00 AM PDT
Perspective: Why less cash means more to tech start-upsSee all Perspectives
Too much money can lead to a lack of focus and can diminish the sense of urgency. Too little money and the fledgling venture may never take flight. But a shared goal of both efficiently capitalizing and successfully building young companies helps both investors and entrepreneurs.
For the company founders, less capital usually means less overall dilution and a greater share of ownership in the company, which ultimately means a larger value from the eventual sale or IPO. That in itself is a good enough reason for savvy entrepreneurs to take less cash.
The reality is that most investors in early-stage ventures are looking to fund companies that return at least 10 times their investment over four to six years. The lower the investment, the lower the threshold for what determines a successful outcome. The result is that a young company can have an outstanding return without having to achieve a stratospheric M&A or IPO valuation.
And if that's not enough of a motivator for entrepreneurs, perhaps they should keep in mind that when too much capital is raised from multiple firms, the interests and agendas of different investors may diverge, which can negatively impact the company's performance.
There are environmental conditions that are also enabling start-up companies to get to market on less capital than in the past. These include the reduction in the cost of hardware due to standardization, the ability to outsource non-core tasks using lower cost labor, and the impact the Internet has on lowering marketing costs for many companies.
On the other side of the coin, so to speak, are the venture capitalists, some of whom are motivated by their large funds to put significant money to work in each investment. But there are more than a few of us who believe that efficient capitalization of portfolio investments supports successful company building.
For one thing, the efficient use of capital requires a greater focus in the company, since resources are constrained. Anyone who's worked in a start-up can attest to this. There's no better mechanism for enabling execution than having the team focused on how they're spending money against very clear milestones. Unlike more mature, profitable companies, start-ups have to keep a low burn rate to get to market. This is particularly true before product introduction, since uncertainties remain about the time frame for market adoption.
That said, minimizing the amount of capital invested is not the end game here--optimizing the amount is. Enabling a start-up to achieve its early key milestones is a critical step in successful company-building, as that company plans for a higher valuation at its next round. A company needs to have enough capital to hit its goals or it may miss the opportunity entirely.
Once the team hits critical milestones on the appropriate amount of capital, it becomes easier to achieve a significant markup in the price at the next round, increasing the value for all shareholders. As progress continues and milestones are met, additional capital can be raised at much higher valuations. This is good news for everyone. A higher valuation reduces the dilution to founders and other employees and reduces the capital required by existing investors to maintain their ownership position in subsequent rounds.
Venture investors who specialize in early-stage tend to raise appropriately-sized funds. Through capital-efficient investing, we're also able to increase the number of the companies we invest in, hopefully creating more potential opportunities for return on the overall fund.
It's true that venture money is flowing freely right now. But the key to successful company building isn't lots of cash. It's the result of the innovation, ingenuity and hard work of the entrepreneurs who apply that cash efficiently to build sustainable companies.
Carl Showalter is a general partner with Opus Capital, a venture capital firm investing in early-stage technology companies. Showalter has also held executive positions at Juniper Networks, UUNET and AOL, and worked as an engineer at Bellcore.